Doubts multiply on Section 89 - Tax Reform Act of 1986

Doubts Multiply On Section 89

The push to repeal the complex new federal benefits law known as Section 89 now has the bipartisan backing of nearly two-thirds of the 435 members of the House of Representatives.

Rep. John J. LaFalce, D-N.Y., chairman of the House Small Business Committee and leading sponsor of the repeal measure, said in early April that 275 other members--128 Democrats and 147 Republicans--were then behind his bill.

LaFalce said he expects that total to go over 300 as uncommitted lawmakers come to understand in the near future that Section 89 is an "administrative nightmare" for employers and a money loser for the U.S. Treasury.

The law is projected to net the government about $200 million this year in taxes on excess benefits provided to highly paid employees.

But LaFalce points out that U.S. employers will spend in excess of $1 billion in fees to lawyers, accountants, and consultants to comply with the statute's complicated regulations. "That $1 billion is all a tax-deductible business expense," he notes.

As a result, he maintains that the taxes collected through compliance with Section 89 will be more than offset by compliance-related tax deductions.

Growing political opposition to Section 89 is putting pressure on House Ways and Means Committee Chairman Dan Rostenkowski, D-Ill., to accommodate the law's critics on Capitol Hill. Section 89 was part of the 1986 tax-reform package fashioned by Rostenkowski, and any bill to alter the law must originate with his tax-writing committee.

While Rostenkowski has been one of few who support the controversial law, he directed his staff in late March to develop legislation to simplify the compliance rules that have caused so many problems for employers.

Aides said the Ways and Means Committee could hold hearings on the chairman's simplification measure soon after it is introduced.

Despite the growing support for repeal, Rostenkowski's opposition remains a formidable barrier to that course. While the House rules contain a rarely used provision for forcing legilation out of committees that decline to act on it, Rostenkowski has powerful resources to oppose any such move.

He has said, for example, that if Section 89 were repealed, he would raise the issue of placing a ceiling on the amount of employee benefits that would be tax-exempt.

Backers of repeal are hoping that information presented at committee hearings on the regulatory burdens of Section 89 will persuade Rostenkowski of the merits of repeal.

Legislation to repeal Section 89 has also been introduced in the Senate by Sen. Robert Kasten Jr., R-Wis., a member of the Small Business Committee. Sen. David Pryor, D-Ark., is sponsoring a bill designed to reduce the time and expense involved in compliance with Section 89. While critics of the law applaud Pryor's effort, most say his bill doesn't go far enough to represent true simplification.

Congress enacted Section 89 in an attempt to ensure that business owners and highly paid employees don't receive unfair shares of tax-exempt benefits, primarily health and life insurance. To that end, the law creates a series of nondiscrimination tests that benefit plans must pass. When a plan does not pass the nondiscrimination test, highly paid employees covered by the plan are taxed on the so-called discriminatory portion of their benefits.

In addition, the law created a set of qualification rules that must be followed if a benefit plan is to receive tax-exempt status.

Congress hoped that the law, which took effect Jan. 1, would prod employers into expanding benefits to rank-and-file workers who now have little or no coverage. But early experience with compliance indicates that some employers instead are reducing coverage.

Ron Danilson, associate director for group underwriting for the Principal Financial Group, in Des Moines, Iowa, says his company has received more than 50 letters from small businesses that have canceled their group health plans because of Section 89's compliance difficulties. "I think this is just the tip of the iceberg," he says.

In our February cover story on Section 89, Nation's Business asked readers to write to us with questions about compliance. Following are some of those letters--reflecting the issues raised most frequently--and answers supplied by experts on Section 89. Q. How does Section 89 apply to an employer who employs people covered by various union health and accident plans? Can all the employees who are covered under multiemployer union agreements be excluded from the individual employer's testing base? George E. Merrill President Reliance Enterprises Santa Rosa, Calif. A. According to the proposed regulations, employees who receive benefits from a plan under a collectively bargained agreement ratified prior to March 1, 1986, are excludable until Jan. 1, 1991, or the expiration date of the agreement, whichever comes first.

The proposed regulations indicate an employer may elect in writing to include collectively bargained employees in the nondiscrimination testing. This election would include all collectively bargained employees and apply to all subsequent testing years. It would not immediately force the qualification rules on a collectively bargained plan; however, highly compensated employees within the collectively bargained unit may be subject to taxation of excess benefits. Q. If we do not have any employees who earn at least $52,235, are we then excluded from compliance with Section 89? Nancy Strong Assistant to the Director Listening Ear Crisis Center Inc. Mount Pleasant, Mich. A. Even if an employer does not have any employees that meet the definition of a highly compensated employee, the employer must treat at least one of its officers as a highly compensated employee for purposes of Section 89. Generally, the employer would designate the officer with the highest annual compensation. Q. What are the IRS filing requirements for Section 89? Holly Myers Personnel Manager Jan-Bell Marketing Inc. Fort Lauderdale, Fla. A. Any amounts required to be included in an employee's income for failure to meet either the qualification or nondiscrimination requirements must be reported by the employer on the affected employee's wage statement (for example, Form W-2). Failure to do so results in the imposition of a nondeductible tax on the employer computed at the highest individual tax rate. In addition, all includable amounts are subject to federal employment taxes, such as Social Security taxes, workers' compensation taxes, etc. Q. What if an employee declines coverage because he cannot afford to pay his share of the health-insurance premium? Are there problems for the employer? Jean Dorsett-Robinson Quality of Life Services Carbondale, Ill. A. Nonhighly compensated employees who decline coverage will not adversely affect results of the eligibility tests since these tests focus on whether an employee is eligible for benefits and not whether he is actually covered. However, unless the employer obtains "sworn statements" (described in recently issued regulations) from those employees not covered indicating that they are receiving coverage under a plan provided by another employer (or that they declined dependent coverage because they have no dependents), they must be considered when performing either the 80 percent coverage test or the 75 percent benefits test. Thus, those employees declining coverage could cause a plan to fail either of these nondiscrimination tests. Q. Must part-time employees be offered the same benefits as full-timers, or are their benefits prorated according to the number of hours they work? Joan Bishop Personnel Coordinator Lexington Public Library Lexington, Ky. A. Benefits need not be offered to part-time employees who normally work less than 17 1/2 hours per week since these employees are excluded from testing. To the extent benefits are offered to part-time employees who work between 17 1/2 and 30 hours per week (the threshold number of hours for full-time status), the employer may proportionately reduce such benefits when performing the tests.

Under the so-called "proportionate reduction" rule, employees working between 17 1/2 and 22 1/2 hours per week who receive a benefit worth at least 50 percent of the full-time benefit may be deemed to receive the same benefit as full-time employees.

Employees working between 22 1/2 and 30 hours per week who receive a benefit worth at least 75 percent of the full-time benefit may be deemed to receive the same benefit as full-time employees. Q. I work for an employee-leasing company. We are considered a co-employer for the clients who contract with us. Will we have to test our company as a whole, with all of our 135 clients and 3,062 leased employees, or just each client on an individual company basis? Pat Woods Little Rock, Ark. A. Both the employee-leasing company and its client companies must include the leased employees in their respective nondiscrimination tests.

The recently proposed Section 89 regulations provide very specific guidance on leased employees. A leased employee is treated as an employee by the client company. This employer can take into account benefits provided to the leased employee by the leasing company. However, in order to exclude the employee from testing, the employee must demonstrate receipt of other health coverage (e.g., "sworn statement").

In addition, the core health benefits received are to be 50 percent as valuable as the most valuable benefit available to any highly compensated employee of the employer.

Conversely, the leasing company could exclude an employee it had leased to a client from testing after obtaining an appropriate "sworn statement" that the client company is providing the employee with core health benefits. Q. We stipulate that all newly hired employees receive only single health-insurance coverage, whereas all those employed before 1987 may receive coverage for dependents. Is this discrimination under Section 89? Ruth E. Terwilliger Secretary/Treasurer Huntsinger's Farms Inc. Hegins, Pa. A. Once the number of nonhighly compensated employees without access to dependent coverage has grown large enough, the dependent coverage will surely fail the nondiscrimination tests. When the dependent coverage fails, any highly compensated employee receiving it will have to include most of the employer contribution toward this coverage in taxable income. Q. We provide medical and dental coverage for all spouses and dependents provided that the spouse is not covered at his or her place of employment, even if he or she has to pay for these benefits. Are we in violation of Section 89 because we require the spouse to pay for benefits at his or her place of employment? Daniel M. Kure President Everett Industrial Supply Inc. Everett, Wash. A. Your program probably will pass the Section 89 tests if you obtain appropriate "sworn statements" permitting you to disregard dependents and employees with other-employer core benefit coverage. It is well to mention a few pitfalls, though: . The other-employer core coverage has to be "substantial." This term is not defined in the regulations, but for a spouse paying most or all of the cost at the other employer, excluding this employee might not pass muster on a close IRS audit. . All dependents must be covered by other-employer coverage in order to exclude the employee's dependents when testing dependent coverage separately from employee coverage. . If the percentage of nonhighly compensated employees whose spouses are required to purchase other-employer coverage is substantially higher than the corresponding percentage for highly compensated employees, then IRS might invoke the "nondiscriminatory-provisions" test (IRC 89(d)(1)(C)), which allows a plan to be declared discriminatory even though it passed the numerical tests, if the plan contains any eligibility provision that discriminates in favor of highly compensated employees. Q. If the owner of a corporation has his family's health insurance paid in full by the company, while the other employees have only half of their families' health insurance paid by the company, is this a violation of Section 89? Linda Gribble Midland, Texas A. This situation does not, per se, violate the Section 89 plan-qualification rules. As for the Section 89 nondiscrimination tests, the situation will almost certainly result in most of the 50 percent extra employer contribution the owner receives being deemed taxable income ("discriminatory excess income"). Q. Must Section 125 (cafeteria benefit) plans meet the requirements of Section 89 in addition to the testing requirements already laid down under Section 125? Clark B. Stowe III, C.P.A. Squyres, Johnson, Squyres & Co. Tyler, Texas A. Those benefits within a cafeteria program that are normally subject to Section 89 must still meet the Section 89 testing requirements on their own. For example, if the program contains life-and health-insurance options, these must be tested for Section 89 nondiscrimination just as they would if provided outside a cafeteria program. However, failure of their respective Section 89 tests would not trigger tax disqualification of the cafeteria plan. Also, other cafeteria benefits (for example, disability income, trading of vacation days) that would not be subject to Section 89 outside a cafeteria plan remain exempt from such testing inside the cafeteria plan.

Looking at matters from the opposite direction, though, if the cafeteria plan fails its Section 125 tests, then the appropriate cafeteria-plan penalties apply to the component health- and life-insurance plans, even though these may have passed their Section 89 tests.

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